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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Sep 28 2015

Lack of Slack Not Coming Back

A key question is whether any major central bank can afford to start a rate hike cycle in the foreseeable future. And if not, are they effectively stuck around the zero lower bound (ZLB)? In that context, it is somewhat surprising to recall that the clamor for an “exit strategy” was already growing in the fall of 2009 – so much so that ECRI felt compelled to push back, by showing the historical lags in developed economy central banks’ rate hike cycles.

Ms. Yellen is understandably anxious to boost inflation from near zero, given her view that the “most important cost is that very low inflation constrains a central bank’s ability to combat recessions.” Underscoring the logic of a near-term rate hike, she noted that the Fed’s expectations-augmented Phillips curve suggests that “economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations.”

But while she blamed low import prices on the strong dollar, therefore considering them to be transitory, the reality is that economies around the world, including those with weaker currencies, have been experiencing import price deflation – and this is not just about energy and commodity prices. Moreover, given the massive and persistent overcapacity in China, it may be wishful thinking to expect import price deflation to go away anytime soon.

Notwithstanding Ms. Yellen’s assertion that “the economy is no longer far away from full employment” and that “prospects for the U.S. economy generally appear solid,” ECRI has already established that it “now exhibits more slack than it has in nearly five years (USCO Essentials, September 2015). Moreover, she now admits that the Phillips curve theory is “still a subject of controversy among economists,” and “inflation sometimes moves in ways that … the model … cannot adequately explain,” undermining its validity, and thus the strength of her own argument.

Ms. Yellen has been valiantly trying to sound confident about the assumptions that underpin her confidence in the state of the economy. Yet it is increasingly obvious that she has doubts. Indeed, when asked last week about the possibility that the Fed might never escape the ZLB, she said she “would be very surprised if that's the case [but] can't completely rule it out.”

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